Refranchising is fast becoming all the rage in the franchising industry. Companies like AFC Enterprises (franchisor of Popeyes and Church's) and CKE Inc. (franchisor of Carl's Jr. and Hardee's) recently announced plans to sell dozens of company-owned stores to franchisees. Tricon (franchisor of Taco Bell, Pizza Hut and KFC) made headlines when its refranchising effort hit a snag, and the company had to give loans to a number of financially strapped franchisees who had purchased company units.

Franchise Zone approached consultants, franchisees, attorneys and companies, including Taco Bell, which was unable to comment, about the pluses and minuses of refranchising. We found that while most people believe poorly executed refranchising can hurt franchisors and franchisees, for the most part, refranchising is seen as a good thing for all involved.

So with all this talk of refranchising, the question remains, is refranchising really helping anyone? To answer this, Franchise Zone spoke with Kenneth R. Costello, an attorney with the Los Angeles law firm of Jenkens and Gilchrist LLP, who has been practicing franchise law for more than 20 years, and Joe Mathews, COO of Southbury, Connecticut-based franchise consulting firm The Entrepreneur's Source and former national director of franchise development of Moto Photo.

How does refranchising benefit those who participate?

Kenneth R. Costello: First of all, understand that, in a sense, franchisees do the same thing. Just recently I read about a Phoenix-based Denny's franchisee selling off 23 of its restaurants to raise capital to reduce debt, essentially a "refranchising" effort by a franchisee. Now they were selling it, obviously, to another franchisee, but when you have large, multiunit operators, they also sell off units for their own reasons. A franchisor selling its units to franchisees increases the number of franchisees, which is generally good for the existing franchisees-you've got more in common with franchisees [than company-employed managers]. And in some respects, the franchisor's raising of capital is good for existing franchisees who now have a franchisor with more capital that can [subsequently] enhance the health of the system.

Joe Mathews: The ability to acquire an existing cash-flowing unit, and use their skills to turn it around, could be an attractive opportunity for some franchisees. If these units are attractively priced, refranchising can create options that might not otherwise be there.

How do you see this possibly hurting franchisees?

Mathews: Franchisees may not get the support they need to make an effective transfer unless there's great communication right down to the store level. There could be employee turnover. There could be employee theft. There could be short windows where cash flow goes radically down and sales go radically down due to the fear of the unknown. Unless that transition is managed properly upfront and everybody knows what it's going to look like before it happens, the cash flow assumptions they make when they buy the business may not hold true. They may be starting off in a worse position than they planned.

What should franchisees be aware of if they're thinking of buying a refranchised unit?

Costello: A franchisee purchasing one or more existing company-owned businesses as part of a refranchising program needs to do careful due diligence and consult with an experienced financial advisor and attorney, preferably one with franchise experience. In addition to other issues pertinent in any acquisition, the buyer should review the franchisor's Uniform Franchise Offering Circular, its year-end audit and most recent unaudited financial statements, and [should] contact existing franchisees and those who have recently left the system. You should also ask to see the actual historical operating results of the specific units being acquired.

Mathews: The company is selling for a reason, so you want to do the same or more diligence on an existing unit that you would do on a new unit. You have to go in with your eyes wide open. You have to have a plan to either maintain cash flow or increase cash flow before you buy. Any operational deficiencies need to be identified upfront. If it's a problem unit, or a turnaround, don't assume the franchisor has identified the reason for the turnaround. Go into the store, work the unit and do your own evaluation, because how you define the problem is how you define the solution.

What, if anything, should franchisors do to make refranchising go more smoothly for franchisees?

Costello: It's in the franchisor and purchaser's mutual best interest that the purchaser be allowed a full opportunity to conduct due diligence, commensurate with the size and nature of the transaction. A franchisor is not typically willing to allow full-blown due diligence where a franchisee is purchasing a single unit, but where a large, multiunit transaction is involved, comprehensive due diligence would be fairly common.

Mathews: For the franchisor and franchisee, it's important to clarify, in writing, what each expects the other to do. Have a smooth transition plan that everyone understands and include the following: clear communication as to the roles and responsibilities for the franchisor and a clear explanation to the employees of the unit as far as what changes are coming and what is expected of them.

Is refranchising working?

Costello: I assume so, because otherwise [companies wouldn't keep doing it]. Overall, the negatives I've heard expressed in the media are about the buyers not doing well after they acquire the units, but it seems to me that's just fundamentally a question of franchisees doing their own due diligence. When the transactions are closed, the franchisors are succeeding in their effort to sell off company-owned locations, so they're successful from the franchisors' perspective. If, at the same time, franchisees don't do well because they've over-financed the acquisition, then, in the long run, it's probably not going to be good for the franchisor because they'll end up selling the units only to have a financially troubled franchisee, which is what has happened in some chains. Unless the franchisor does an all-cash deal, they're not going to end up getting the full purchase price either because the buyer has failed.

Mathews: Refranchising doesn't work in many cases for three reasons. First, parent companies are hard pressed to make the ideological shift from centralized control of the businesses to franchisee control. Second, high-flying public companies need sales and earnings to grow their stock. The centralized approach, not refranchising, works better for this process, as the market does not highly value most public franchisors. Third, refranchising can jeopardize the quality control of products, services and appearance. Instead of looking to refranchise, parent companies that are stretched too thin may look to improve quality control and, consequently, sales and stock performance.

The Franchisor's Perspective

Franchise Zone: Why do companies refranchise? What are their goals?

Kenneth R. Costello: Typically, [with the companies] you've heard about recently, the goal is an effort to raise capital and pay off debt by franchising units and selling off company-owned operations. But there's also just a philosophical difference, where different management groups perceive they should be more company-owned or more franchised. So it may just be a re-emphasis on franchising where a prior administration was more inclined to develop through company-owned [units].

Joe Mathews: When companies refranchise, often it has to do with just getting better execution on the store level. They feel there's some sort of loss of control or disconnect on how they're operating particular units, and sometimes it's a move back to their core competency, which is franchising. If they can't control it from a strong central authority, they refranchise it and give up control to get the better execution. Generally when they refranchise, it's a turnaround strategy. Usually units are going down financially and it's an attempt to correct that.

How does refranchising benefit franchisors?

Costello: One of the benefits is that it's a way to use the entrepreneurial skills of franchisees who have financially invested in a unit vs. putting a store manager in a unit. There's a tendency for franchisees to work harder. Their capital is at risk, so they're more attentive to the operations and the profitability of the units. Certainly company-owned units that are marginally profitable can very often be run more profitably by franchisees. By refranchising, you're taking advantage of the skills and the entrepreneurial energy of franchisees. The franchisor, in the short run, raises capital by selling the unit, but then ultimately shifts the management to a franchisee, who presumably will do a better job of running it.

Mathews: Refranchising focuses the franchisor on franchising and away from operations. It keeps resources aimed at franchisees, which is the core competency of most franchisors.

Can refranchising hurt franchisees?

Costello: I suppose it could hurt franchisees if they aren't using their doing due diligence to make sure the purchase is viable and the purchase terms are fair.

I've heard that in some recent refranchising efforts, the franchisor was just interested in getting as much as they could for the units to the detriment of the buyer. But at the same time, if the buyer is reading financial statements and paying attention, you wouldn't think that would be a problem. If you're buying many, many units, you're presumably a sophisticated buyer and know what you're getting into.

Can refranchising hurt franchisors?

Mathews: It can hurt a franchisor, yes, because on the store level, you're talking about a dramatic culture shift. It's a radical change, and anytime you have that radical of a departure, people will resist it. So it does create turnover; it can create ill will. Unless the change is managed properly, it could actually blow up. It has to be managed all the way through the organization

Unless all departments are communicating and they're clear on what the objectives are, you're actually creating conflict within the franchise. Existing employees, on the store unit level, because they may have a fear of the unknown, may start quitting, which actually hurts cash flow during the transfer.